It’s time to fix the charitable deduction

FORTUNE — As elected officials in Washington struggle to find common ground on the deficit, it seems inevitable that tax breaks — which, unlike tax rates, have been targeted by both parties — will be on the chopping block. That includes the charitable deduction, which taxpayers can claim for donations to hospitals, colleges, churches, and other nonprofits. The Joint Committee on Taxation estimated that the tax break will cost the government $246 billion between 2010 and 2014.

The threat that lawmakers might eliminate — or even curtail — the charitable deduction has sent non-profits into a panic. The Charitable Giving Coalition, whose members include the United Way and the American Red Cross, recently announced plans to gather in the nation’s capital on December 4th for a campaign called “Protect Giving – DC Days.” The Independent Sector, a trade group for nonprofits, set up a website asking people to entreat their representatives to leave the deduction alone.

“We’re seeing talk that we’ve never seen before, which suggests that we have a real issue here,” says Diana Aviv, the head of the Independent Sector. Aviv says the tax break for donors should be protected because of its unique attributes. “The charitable deduction is not the same as other deductions,” she says. “It doesn’t benefit the individual.”

Aviv is partially correct: the charitable tax break is different from many other tax breaks in so far as it clearly contributes to the public good. But the deduction does benefit individuals — especially those in the upper class. According to a report by the Congressional Budget Office, taxpayers who make more than $100,000 a year took in 76% of the total charitable tax subsidy in 2006, despite contributing 57% of all donations. When wealthy people give money to charity, they reap outsized rewards.

Why the current deduction is unfair

There are several reasons for this discrepancy. First, the tax break is a deduction, which means it can only be claimed by people who itemize their tax returns. That rules out the 70% of taxpayers who don’t itemize. Second, because the expenditure is structured as a deduction, people in higher tax brackets can use it to net greater savings. Say a person in the 35% tax bracket donates $1000. If he or she deducts the contribution, his or her tax bill is reduced by 35% of $1000, or $350. Meanwhile, someone with a tax rate of 20% who donates the same amount of money will only save $200. As a result, it’s cheaper for wealthy people to donate money.

By giving the rich a bigger incentive to donate, the government is effectively granting them greater control over the country’s charitable giving. The subsidy is funded by all taxpayers, but the causes favored by the wealthy do not necessarily benefit everyone. PIMCO chief Bill Gross, himself a prominent philanthropist, told the New York Timesin 2007 that he thought wealthy donors were over-compensated for giving money to “football stadiums and concert halls.” Gross added: “I don’t think the public would vote for spending tax dollars on those things.”

While lower-income taxpayers give 10% of their total donations to “basic needs organizations,” according to the CBO, millionaires divert just 4% to such groups, preferring to donate to the arts and education sectors. Some of those donations are used to pay for scholarships and charitable causes that benefit society at large, but other funds go to wealthy schools in high-income areas In those cases, the government is essentially paying the rich to donate to their own communities.

Of course, many donations do go to worthy causes, none of which deserve to be starved of funding. But there’s reason to believe that the charitable sector may be overstating the threat of a reduced tax break. Take, for example, the Charitable Giving Coalition’s recent letter to President Obama, who proposed a couple of years ago that taxpayer deductions be limited to a rate of 28%. The Coalition argued that “any cap or limitation on charitable deductions” would undermine giving, with “long-lasting negative consequences.” The Tax Policy Center has estimated that Obama’s proposal would reduce private giving by about 2%.

That figure looks even smaller when you put it in the broader context of charities’ revenue. In 2010, the nonprofit sector derived just 13% of its intake from private contributions. If you exclude hospitals and higher education organizations, which make most of their money from private payments and government sources, then the proportion of funding from private contributions increases to 24%.

Because the deduction has experienced little disruption since it was created in 1917, we cannot be absolutely sure what would happen if it were eliminated or cut. But there’s reason to believe the effects would be smaller than previously thought. In recent years, several economists who have studied the price elasticity of giving, which is the percentage by which donations would decrease if the cost of giving were to go up, have found that the ratio is less than -1 — meaning that, if the price went up by 1%, the level of giving would decline by less than 1%. A 2010 report by the Congressional Research Service points out that, historically, giving has not changed very much in response to changes in tax rates.

Many wealthy taxpayers say they would continue to donate if the deduction was reduced. In response to a recent survey conducted by the Center on Philanthropy at Indiana University, 50% of high-net-worth households said that they would give the same amount of money if the tax break were completely eliminated. “People tend to forget that some of the most significant giving in the U.S. dates back hundreds of years,” says Rob Reich, an associate professor of political science at Stanford. “The Rockefellers and the Carnegies created foundations in the absence of any incentive whatsoever.”

How to fix it: A floor and a credit

The charitable deduction is inequitable, costly, and inefficient. And yet, it should not be abolished altogether. For one, although economists have attempted to gauge the impact that eliminating the tax break would have on giving, the outcome is still uncertain; no one really knows what would happen (and which charities would suffer the most). Meanwhile, it’s possible to reform the tax break and cut the subsidy while minimizing the impact on charitable giving.

Several politicians and think tanks have suggested that the tax break could be limited through the addition of a cap. An absolute dollar cap on deductions — an idea promoted by Mitt Romney during his presidential campaign — has been gaining steam. Such a proposal would effectively wipe out the charitable deduction, though, because most people who itemize would first claim a deduction for their mortgage, which would consume most, if not all, of the allotted tax break. President Obama’s proposal for a 28% deduction cap — described earlier — would improve the structure of the tax break without hurting giving too badly, but it wouldn’t raise very much money for the government.

A floor, which would force people to donate a certain amount of money to claim a tax break (and would exempt the money below the floor from the break, lowering the subsidy), offers a more elegant solution. The only people who would who would donate less as a result of a floor would be those who contribute small amounts; for others, there would be no reason to reduce giving at the margin. According to the Tax Policy Center, instituting a floor of 1.7% of adjusted gross income would raise $10-11 billion in annual revenue without affecting contributions at all. The CBO estimates that a floor of 2% of income would raise $15.7 billion while cutting donations by $3 billion.

The government could save even more money by converting the deduction into a tax credit, which would allow donors to claim a flat percentage of their donations. The CBO found that, if the charitable deduction were changed into a 25% credit with a floor of 2% of income, the government would cut the total subsidy by $11.9 billion a year, while donations would shrink by a mere $1 billion. A 15% credit would raise $24.6 billion, with donations falling by an estimated $10 billion, according to the CBO.

In the long-term, the savings would be significant. The Committee for a Responsible Federal Budget has estimated that changing the deduction to a 15% credit with a 2% floor would save the government $340 billion over the next decade, reducing the subsidy by 60%. Donations, meanwhile, would only decline by 4.9%. (The Bowles-Simpson commission proposed a similar, if slightly more draconian, 12% credit with a 2% floor.)

In addition to saving the government money, replacing the deduction with a credit would also make the system more equitable. All people would be equally compensated for giving to charity, regardless of their tax bracket. A credit would also reward the 70% of Americans who don’t itemize their taxes, which might spur additional donations.

Such changes would inevitably change the profile of giving in this country, or at least the composition of donations that are subsidized by the government. People who make under $100,000 a year currently allot 67% of their donations to religious organizations, according to the CBO. Expanding the tax break to lower-income citizens would inevitably skew the subsidy toward churches.

This is a bad result. Not because it would compel taxpayers to fund widespread religious donations — though many people would surely oppose such a large subsidy — but because it would be wasteful. Studies have shown that the price elasticity of giving for religious donations is relatively low, which means that people would be unlikely to cut their gifts in response to a lowered tax break. Indeed, many religious donors do not currently claim a deduction.

If the government is serious about saving money, then it should consider exempting religious donations from the charitable tax break. Most people give to churches because they want to, not because they get a tax break for their generosity.